Cameron Luke Wilson

The Return of Depression Economics A Book Review Wilson, Cameron WLSCAM003 School of Economics University of Cape Town Krugman, P. (2009). The Return of Depression Economics and the Crisis of 2008. New York, London. W.W. Norton Paul Krugman, an economics Nobel laureate, does not hold back in this hard-hitting account of international financial crises. Krugman sets the stage for the “inevitable ‘Mother of all Credit Crises’” devastating global financial markets. Drawing from lessons forgotten, Krugman systematically guides the reader through economic shocks, which decimated economies, preceding the fateful day of September 15th, 2008. Summary The reader is at once confronted with Krugman’s brashness. He quotes, “the central problem has been solved”, referring to the printing of money to “tame” business cycles and rescue an economy from depression. Krugman makes use of a running metaphor throughout the book: the “baby-sitting co-op” - a micro economy. The co-op essentially runs on labour (hours spent baby-sitting) and currency (coupons earned through baby-sitting to be saved or spent). The use of the co-op demonstrates the effects of over saving resulting in liquidity deficiency caused by economic shocks and its effects on a micro-economy. The metaphor is then extended to the real workings of a macro-economy. This allows the reader to manifest Krugman’s solutions to past failures using his thought experiment. Krugman focusses heavily on how the failure of financial and fiscal management, reform, regulation, and moral hazard led to, and sustained depressions in developing economies. Finally, Krugman demonstrates his arguments through precise and convincing recounts of past financial and fiscal mishaps, creating an exceptional sequence of events leading up to the most devastating market failure in living memory. Critical Evaluation “The Return of Depression Economics” covers a multitude of financial crises, from Argentina’s currency meltdown to the sub-prime mortgage crisis. Each crisis has similarities to every other mentioned in the book; lending to the idea of “lessons not learned, but forgotten”. Krugman effectively ties up the links between each crisis and demonstrates how global contagion attributed to the spread of economic meltdown to seemingly stable economies. It is important to give a rundown of each crisis to truly understand Krugman’s contribution to the field of “Depression Economics”. The Tequila Crisis, Mexico, and Latin America, 1994 Leading up to 1994, immaculate growth in the Mexican economy, the “Mexican Miracle”, resulted in foreign capital inflows in excess of $30 billion. This ‘miracle’ was a result of an oil boom of the 1970’s followed by the election of Salinas, a free market reformist. Salinas’ success was built on the mitigation of the debt crisis as well as on the North American Free Trade Agreement (NAFTA). The combination of debt relief, the NAFTA, and liberalisation of the Mexican economy led to an impressive inflow of foreign capital which was then followed by a Dollar/Peso currency peg. Inevitably, this caused the overvaluation of the Mexican Peso. Authorities botched the devaluation process, causing investor panic and capital flight, thereby crashing the Peso. The contagion spread to Argentina due to their currency peg to the US Dollar. The devaluation in the Mexican Peso led to a downward pressure on the Argentine Peso. Argentina’s exports became uncompetitive, resulting in depression. Japan’s Trap,-’s A widely cited factoid suggested that the land within one square mile of Tokyo’s Imperial Palace was worth more than the state of California in the 1990’s (Krugman, 2009:61). Krugman suggests that this real estate bubble was Japan’s equivalent to the roaring twenties caused by frivolous debt-fuelled speculation and moral hazard. The bubble burst followed by increased government spending and a reduction in interest rates to stave off depression. Japan soon found itself in a liquidity trap followed by stagnant growth and increased government deficits. Japan’s “lost decade” has led to increased government spending and a debt to GDP ratio of roughly 250% as of 2017 (TradingEconomics.com). Asia’s Crash, 1997 Thailand experienced increased growth leading up to 1997 through debt-financed moral hazard, cronyism, and speculation. Japan’s meltdown resulted in a weaker Yen making Thailand’s exports less competitive, thereby reversing Thailand’s “credit machine”. Loans went bad, sterilisation attempts eventually failed due to reserves running dry, and increased rates were the flavour of the day to keep the Baht competitive. Speculative attacks and panic left the government no choice but to devalue the currency. Much like Mexico, Thailand hashed its devaluation as it was primarily worried about comforting investors – “win market confidence at all costs” - rather than letting market forces dictate the Baht’s value. Thailand thus slipped into a classic currency crisis induced depression. The contagion led to a selfvalidating panic in many Asian economies, demonstrating the potential dangers of interrelated economies, speculative attacks, and panic driven bank runs. ‘Hedge’ Funds & Speculative Attacks: The Pound & Hong Kong Leading up to Krugman’s analysis of the 2008 Global Financial Crisis, he comments on the roles of speculation and leveraging in the financial system. He draws spectacularly from George Soros and his speculative attack on the Pound in 1992. Soros, again, launched a speculative attack on Hong Kong with other hedge funds to capitalise on leveraged positions in the market. Essentially, they betted against Hong Kong’s Currency Board with its one-toone peg on the Dollar. Astonishingly, Honk Kong abandoned its free market ideology and fought back, beating the hedge funds. These speculative attacks highlight the lack of law enforcement on the matter. It is illegal to fix markets, but it was not illegal to fix economies. Without a Bang, but with a Fizzle: The Run up to 2008 The mid 90’s saw incredible growth in the technological space with the likes of Yahoo!. Most investors were comfortable with the prospect of Yahoo!’s operations requiring an annual growth rate of 95.5% - absurd by today’s standard - yet, so long as there were debt-fuelled investors willing to buy, prices of the stock remained artificially propped up (Estrada, 2011:204). The same went for other dot.com initial public offerings. The dot.com bubble burst resulting in a recession which was ironically saved by another bubble. The bubble which ended the 2000 US dot.com recession was that of the housing market. So long as there are willing buyers, prices could only go up. With soaring housing prices and the advent of collateralised debt obligations (CDO’s), investors found government backed mortgages to be very attractive investments. Mortgages of different credit ratings were grouped up into CDO’s of differing risk and sold to investors. Investors and investment banks levered their positions heavily in the process. This operation became exceptionally profitable. Once all the credit-worthy borrowers had mortgages, investment banks had no more mortgages to purchase from brokers which led to relaxing credit ratings and lending to sub-prime individuals. Sub-prime borrowers defaulted on their mortgages resulting in fewer mortgage payments for their respective CDO’s. Investors and investment banks began to sell off their houses to recoup lost mortgage payments, leading to an increased housing supply, thus resulting in sinking mortgages (when the value of a property sinks below the mortgage value). This led to a major selloff of assets with parties owing tremendous amounts of money to other parties due to their levered positions. Simply put, there was a serious case of liquidity deficiency in the economy. The culmination of the vicious cycle of deleveraging led to the official spark of the Great Recession, the bankruptcy of a key shadow banking institution, Lehman Brothers, on September 15th, 2008. Krugman Justified? It is now possible to understand how Krugman backs his arguments. Krugman chalks up market failures to government intervention – or lack thereof in the Great Recession’s case – and mismanagement of fiscal and monetary policy. For instance, Both Mexico and Thailand hashed their currency devaluations leading to panic and bank runs. Krugman states there are two important rules for currency devaluation: 1) Make devaluation large enough to stop downward speculative pressure 2) Give every signal possible that all is under control going forward If these two simple rules are broken, panic will ensue; leading to credit crises, as evident in Mexico’s and Thailand’s cases. Krugman also makes a sound but invalid argument for monetary intervention; printing money to eliminate liquidity deficiencies in an economy. He makes use of his co-op metaphor: simply through printing more coupons, there would be more opportunities to baby-sit and spend coupons. Expand this into the life-sized economy, the result is increased liquidity which results in more opportunities to earn and spend money, resulting in economic growth. In Japan’s case, moral hazard and debt-fuelled real estate bubbles followed by poor fiscal planning (long term fiscal expenditure projects) ultimately resulted in Japan’s lost decade. Krugman states that trying to fix immediate demand deficits in an economy with long term projects only elongates a depression. Japan’s long term public projects could only yield financial returns in the relatively far future, thereby lending little help to the demand deficit at the time of Japan’s depression. It is important to note how Krugman focuses extensively on demand side economics, lending to the idea of Keynesian economics during the interwar years of the 20th century. According to Krugman, lack of regulation over the shadow banking sector was the key cause of the 2008 Great Recession. The contentious point is that of the regulation of the banking sector in contrast to the regulation of the investment (shadow) banking sector. Krugman firmly believes that more safety nets, accompanied by regulation of [all] financial institutions would have avoided the credit crisis of 2008. Krugman finally concludes his analysis with a rather anticlimactic set of policies - Financial reform - Regulate risky, but essential, areas - Extend regulation - Implement restrictions on international capital flows - Revisit Keynesian policy tools There is no doubt that any work from a Nobel laureate would be, at worst, rather interesting. Krugman has managed to give a very polished history lesson on international financial crises. He has managed to link concepts and show how lessons forgotten lead from one crisis to another. Most importantly, Krugman demonstrates, that although most crises were interrelated, they are still very much context specific. Thus, taking broad sweeping policy approaches is simplistic at best and offers no value to policy makers. Krugman Refuted Every crisis visited in the book has a similarity to another crisis, yet is unique given its context. Krugman understands this and even went as far as bashing the idea of implementing a broad set of policies such as the Washington Consensus. However, Krugman concludes his analysis with a broad policy set of his own, offering no real value - a last-ditch effort to neatly tie up his book. The issue of simply printing money to create liquidity in a market to solve depressions is probably Krugman’s most contentious opinion. As per the quantity theory of money, increasing the supply of money only leads to increased prices which translates to increased inflation rates, ceteris paribus. Printing money does not affect real output. Therefore, artificially propping up prices merely destroys consumer purchasing power, which lowers levels of consumption, decreasing output, thus worsening a recession, ceteris paribus (Pettinger, 2008). Krugman highly suggests that moving towards Keynesian policies would be the way forward; implementing a dated doctrine, once prominent during humanity’s greatest era of conflict. However, it is important to remember the failures of Japan’s fiscal stimuli, which Krugman seems to have forgotten, when advocating Keynesianism. Two major issues arise when contemplating Keynesian economics; - Keynesian economics is dated - Keynesian economics is context specific Keynes was prominent in a time of great conflict, where the world’s greatest public works programme, World War II, came knocking several years after the Great Depression. The culmination of economic duress and the advent of Europe’s problem child running amok created the perfect economic climate for state intervention. However, given today’s relative peace and lack of major depression, Keynesian economics is of little value as it lends itself to the idea of “fiscal stimulus” through worsening budget deficits and inefficiently investing taxpayers’ money through troubling bureaucratic decision making. Finally, Krugman’s idea of increasing safety nets is contradictory to his distaste for moral hazard. The mere practise of having big-government bailout essential financial institutions incentivises said institutions to take on risk they would never have taken on if they were fully accountable initially. Krugman argues that regulation in conjunction with said safety nets eliminates the issue of moral hazard. However, increased regulation creates many problems of its own in the form of market failures and inefficiencies. Central planning and state control of key economic activity does not allow an economy to run efficiently as possible, as evident by the failed centrally planned economies of the 20th century. The main issue is not that Krugman implements faulty policies. The main issue is that Krugman states that the key concern is policy mismanagement instead of fundamental issues with global governance. Thus, it is important to rather analyse governance and tackle the key institutional failings of current ‘big-government’ rather than reckless policy. Conclusion Krugman expertly compares and contrasts economic depressions and gives the reader valuable insight as to how such economic failures occur. The Return of Depression Economics is more useful as a history book rather than an academic piece used for policy implementation. It is thus advisable for the reader to cross reference Krugman’s policy recommendations and consider other viable alternatives to deficit expenditure or government seigniorage opportunities. 2181/2200 Words (10% leeway as customary of SoE essays) Reference List Krugman, P. (2009). The Return of Depression Economics and the Crisis of 2008. New York, London. W.W. Norton Japan Economic Indicators. Available: https://tradingeconomics.com/japan/indicators [2017, September 25] Estrada, J. (2011). Understanding Finance. A no nonsense companion to financial tools and techniques. Great Britain. Prentice Hall second edition Pettinger, T. (2008). Printing Money in a Recession. Available: https://www.economicshelp.org/blog/996/economics/printing-money- in-a- recession/ [2017, September 30]